Investment and interest rate policy in the open economy

This paper analyses the necessary and sufficient conditions to ensure that interest rate policy does not introduce real indeterminacy and thus self-fulfilling fluctuations into open economies. A key feature of the model is the incorporation of capital and investment spending into the analysis. The conditions for real determinacy are examined for two measures of inflation that central banks' can target in open economies: domestic vs consumer price inflation. In stark contrast to previous studies, in the presence of investment activity monetary policy that targets domestic price inflation is more susceptible to self-fulfilling fluctuations than monetary policy rules that target consumer price inflation. However, the problem of indeterminacy identified under domestic price inflation can be ameliorated provided the policy rule also responds to either the exchange rate or to output. Copyright 2011 Oxford University Press 2011 All rights reserved, Oxford University Press.